The (Many) Things Macroeconomists Don’t Know

Jean-Claude Trichet, now a few months into retirement, has no regrets about his eight-year tenure as president of the European Central Bank. At least, that’s what he said at Harvard’s Kennedy School Thursday night when a student asked him point blank. “I don’t regret anything,” was the response.

But listening to the full talk (when there’s video, it will be available here), it was clear that Trichet did regret something about the last few years. He regrets that economists didn’t give him better advice.

What Trichet said was that state-of-the-art macroeconomic theory was almost entirely useless in dealing with the crisis that began in 2007. Yeah, he tried to be polite about it: “This doesn’t mean we have to abandon DSGE,” he said, referring to the dynamic-stochastic general equilibrium models — in which an economy of rational, far-seeing actors struggles with the occasional friction or shock, but generally gets along okay — that dominated the work of economists at central banks. Buuut “atomistic rational agents [the figures that populate DSGE models] don’t capture behavior during a crisis.” Another quote: “Rational expectations theory has brought macroeconomics a long way … but there is a clear case to reexamine the assumptions.” And neither of these approaches leaves room for the possibility that financial market fluctuations could be the source of problems for the real economy.

Trichet finally reached for the last refuge of the frustrated economic policymaker: John Maynard Keynes. He quoted (at length) a famous story from Keynes’ General Theory. It describes a beauty contest in a newspaper where the goal is to pick the face that the most readers will vote for.

It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

“It captures what’s happening when a systemic crisis is unfolding,” Trichet said. At the height of the 2008 crisis, he went on, “it was clear that an immensely large number of [market] participants were thinking that if there was not a game change, the system would collapse.”

Now, none of this is exactly news. Lots of people have said similar things over the past couple of years. But it was very interesting hearing them from someone who until recently was one of the most powerful economic policymakers on the planet — and one who has been criticized mainly (at least among English-speakers; the Germans have their own unique view) for being too conservative, and too unwilling to jettison faulty models of how the world works. Not that he has any regrets or anything.

Trichet’s analysis nicely parallels the chapter on postwar macroeconomics in a fascinating new book I’ve been reading, The Assumptions Economists Make, by Jonathan Schlefer. Schlefer is a former alt-weekly columnist and editor of MIT’s Technology Review who quit journalism to get a Ph.D in political science, and is now a research associate at Harvard Business School. His book is a tough critique of economics, but a deeply informed and sympathetic one. And his basic attitude is pretty much the same as Milton Friedman’s in the famous essay “The Methodology of Positive Economics.” It’s okay if an economic theory is unrealistic and oversimplified. All that matters is whether it delivers useful predictions.

By that standard, here are Schlefer’s judgments on the succession of theories that have dominated academic macroeconomics since the 1970s:

Rational expectations (which proposed that we’re all too smart to be fooled by money-printing central bankers and deficit-spending governments): Intellectually interesting, and maybe helpful in “normal times,” whatever those are. But not very good at describing or predicting the actual behavior of the economy at any time, and worthless in a crisis.

Real business-cycle theory (which says that economic ups and downs are all caused by technology-induced changes in productivity): “[N]ot only are these models a tautology — they are a tautology that turns out to be wrong. They say that employment rises or falls because actors choose to work more when productivity is high and less when it’s low. This is nuts.”

DSGE (sometimes called “New Keynesian”) models: Not “quite as bad as they sound,” as they do describe an economy that moves along by fits and starts. They just don’t leave room for any crazy stuff.

Which brings us, and Schlefer, and Trichet, back to Keynes. The Keynesians of the 1950s and 1960s — who were overthrown by the rational expectations revolution and the stagflation of the 1970s — overstated what they knew about the workings of the economy, he writes:

If only they had stuck with the pragmatic claim of having a somewhat helpful model, useful in thinking about important aspects of the economy while missing others! Unfortunately, their rhetoric made politicians and the public think economists knew more than anyone could. It ultimately resulted in worse disillusionment with their approach than was deserved.